India's New Leaders May Demand Interest Rate Cuts

The voting in India’s national election ended on May 12. With exit polls showing opposition leader Narendra Modi’s Bharatiya Janata Party winning a clear mandate over the incumbent Congress Party, the Sensex stock index hit an all-time high amid confidence the BJP would be able to form a pro-business government, but the good cheer may be misplaced.

India’s economy is still in the dumps. Consumer prices in April jumped 8.59 percent from a year earlier, the government announced on May 12. That’s up from 8.31 percent the previous month. The same day a separate survey showed industrial production fell 0.5 percent year over year in March, the fourth decline in the past six months. “The new government will be inheriting a stagflation-type situation,” says Rupa Rege Nitsure, chief economist at Bank of Baroda in Mumbai.

Thanks to that brutal mix of high inflation and low growth, the most contentious relationship in Indian politics could be between the new prime minister and India’s U.S.-educated central bank governor, Raghuram Rajan. The onetime chief economist at the International Monetary Fund who earned his doctorate at the Massachusetts Institute of Technology, Rajan became governor of the Reserve Bank of India last September. Since then he has raised interest rates three times, helping reverse a steep slide in the value of the currency. The rupee, which plunged in the months before Rajan’s arrival at the RBI, has gained 12 percent since September. The benchmark interest rate is 8 percent.

Rajan’s hawkishness hasn’t yet translated into victory over inflation, which averaged 10 percent last year and is on the upswing again. His interest rate increases have made him a target for politicians frustrated by tepid growth. During the campaign, BJP Treasurer Piyush Goyal told the Economic Times, an Indian daily, that Rajan was “only aggravating the problems by increasing interest rates,” although he later said he had no agenda to remove Rajan. Arun Jaitley, who may become finance minister under Modi, has said high rates are hurting the economy, while senior BJP figure Subramanian Swamy has stated Rajan should go. Unlike the Federal Reserve, the RBI is not independent of the government.

Rajan has dismissed talk of a showdown with the BJP, but shortly before the voting ended, he told an audience in Switzerland that “I determine the monetary policy. I say what it is. Ultimately, the interest rate that is set is set by me.”

Under Prime Minister Manmohan Singh, the Congress-led government made little headway in addressing structural problems such as infrastructure bottlenecks that fuel inflation. India’s fight against inflation still depends in large part on the monsoon, which provides the water farmers badly need. The government is forecasting a below-average monsoon this year, which could drive up food prices. The new government will also face pressure to cut costly energy subsidies that contributed to a budget deficit of 4.6 percent of gross domestic product in the fiscal year ended in March. Modi “has to consolidate the fiscal side, which means slower growth—which may then raise pressure on the central bank” to cut rates, says Frederic Neumann, co-head of Asian economics research at HSBC (HSBC).

Although relations between Rajan and Modi promise to be contentious, the BJP probably won’t oust the central banker. Firing one of the few widely admired Indian policymakers would send the wrong message. “The new government will gain a lot of heartburn if they end up messing around with him,” says Rajeev Malik, senior economist with CLSA. Still, with the inflation outlook darkening, the new leaders may be unable to resist picking a fight with the man who sets India’s rates.